The
drama of the personalities has been so intense I think that many
investors who watch this stock, think that there will be some kind of
quick dramatic resolution. In this post I will argue that there will
not be. I do think that the odds favor one side over the other but I
think that we are a very very long way from a resolution, and when it
comes most people who trade the name will not be part of it.

First,
let's have a look at Ackmans position. He has done 18 months of
research and has made a massive presentation outlining it. When the
company responded that he simply didn't understand their business he
sent them a list of 284 follow up questions and dared them to answer
them. In summary, the Ackman thesis is that Herbalife is nothing more
than a pyramid scheme. An extremely well managed one, but a pyramid
scheme nonetheless.

He claims that the primary rewards to
distributors are generated not by actual sales but by recruiting new
distributors. In support of this thesis he points out that the
company does not really track sales to end users and accuses the
company of overstating the value of its sales by recording them
generally at the suggested retail price when in reality many of these
products are available on the internet not only below the SRP but
also below the levels implied by the distributor discounts.

He also
makes the following additional arguments if I may paraphrase his
executive summary: 1.) the company exaggerates the chances of success
as a distributor, 2.) the company exaggerates the rewards of being a
distributor, 3.) there is a high failure rate for distributors, 4.)
Herbalife has been the subject of litigation on this issue 5.) the
company targets the poor, 6.) the company hides its true nature
through obfuscating its compensation scheme, 7.) Herbalife
distributors quickly saturate their markets, and 8.) the top 1% of
distributors earn almost 90% of all rewards.

Of
course, as is well known, Ackman did more than just claim this was a
pyramid scheme. He announced his belief that all pyramid schemes are
ultimately destroyed, either by running out of new suckers to become
distributors or by legal action on the part of the regulatory
authorities. Ackman expressed his belief that one or both of these
outcomes was likely in the near future. As a result he
decided to short 20% of the float of the company, about $1
billion worth. He announced that his target price was zero. As you
might imagine the shares of the company cratered, falling from the
$40s to the $20s in short order but then began a rather miraculous
levitation and have whipsawed around $35 with all the recent news.

Ackman
is an excellent dramatist and clearly his firm is thorough. The
presentation is well made and has a good narrative arc. It is very
long but it doesn't feel like it takes a long time to read and at
first glance it seems pretty convincing. There are a number of
factors, aside from his research and presentation skills, which help
Ackman in this case.

First of all is the way that the regulatory
authorities work with regard to pyramid schemes. They
never come out and say “this company is NOT a pyramid scheme.”
This is quite logical because there would be nothing to stop someone
from then turning such an officially sanctioned firm into a pyramid
scheme. So the only proof that the authorities will not intervene in
HLF is that that are not intervening, which they may do at any time.
Thus there is no way for them to definitively disprove Ackman.

Second
there are a great many regulators involved. The FTC and the SEC at
the federal level and all 50 state Attorneys General, so Ackman has
52 bullets and as he has said, all it takes is one. This is quite
true. Ackmans publicity campaign, if successful enough, also has the
capacity to materially harm Herbalifes ability to recruit new
distributors or frighten old ones thereby hastening the effect that
Ackman claims is already underway. Ackman is also helped to some
extent by the company itself. Whether it is a pyramid scheme or not
it certainly does not keep records clearly enough to instantly
demonstrate that it is not one. So, Ackman talked a good game and
once you read the presentation you can see why the stock went over a
cliff after it.

That
said, there are a few very important weaknesses to Ackmans case, some
of which were pointed out in the Loeb letter. Loeb pointed out that
no pyramid scheme has ever survived for more than 10 years and that
the majority of those that the FTC shuts down are exposed in less
than 5 years. HLF has been in business for 30 years, that's quite a
lot of time for a pyramid scheme to survive. While the Loeb letter
makes some interesting points I think he is remarkably silent about
some of the other weaknesses of Ackmans position.

The
first weakness I think is the most glaring: the size of the position
itself. HLF has about 108 million shares outstanding. Ackman is short
20 million of them. Now remember before HLF became the darling of the
daytraders it traded about 1.5 million shares a day, and let me
assure you that once it's known that Ackman is a buyer that's the
same side the day traders will be on, so that 1.5 million shares is a
good estimate for the real interest in the name. That means that in
order for Ackman to close his position he would have to be, under
normal circumstances, 100% of the buyside volume for an entire month.
Even in the event that he was able to do that in secret, he would almost certainly drive the price much higher. In the event that he was not able to keep it a secret so many people would try to front run him he would soon have to seek an off exchange accommodation with someone who happened to have a lot of shares. I think his price target is zero for a very good reason: short of the
company going to zero he can't get out.

Then there is the issue of the catalysts which
would send the stock to zero, remember: it is not enough that Ackman
be correct that HLF is a pyramid scheme, it must be a pyramid scheme
that comes undone on a time horizon that rewards him and his
investors. If HLF keeps the thing going for another 30 years he's in
big trouble.

There
are basically two things that could kill HLF and Ackman correctly
identifies them: regulatory intervention or total market saturation
and/or a depleted supply of idiots/distributors. It's true that
Ackman gets 52 bites of the regulatory apple but lets look at that a
little more closely. He correctly points out that HLF targets the
hispanic community. The company has something like 360,000
“distributors” and 90,000 “sales leaders” there's some
confusion as to what this means but these people believe that
Herbalife is a business they own. Let's imagine for a moment that you
are a state AG, how eager are you to shut down a business which has
millions of end users and tens of thousands of micro-entrepreneurs,
who just happen to be members of an extremely important voting bloc?
What's more, even though Ackman has promised to give his share of the
spoils to charity, whoever kills HLF will be seen to have done the
bidding of a New York billionaire hedge fund manager. You'll need an
alchemist like Axelrod to live that down but Axelrod probably won't
take your calls.

“But wait!” our hypothetical AG might exclaim, “I'll be a
hero if I shut this thing down because obviously it is victimizing
these people.” Will he? Is it? HLF has 90,000 sales leaders,
around and a 50% "retention rate" meaning 45,000 of them fail every year but that 90,000 number is pretty consistent so they are also replaced by another
45,000, every year. Yet the FTC has received only 210 complaints over the past
several years. How can that be? In the past 5 years hundreds of
thousands of these micro-entrepreneurs have failed but generated only
a handful of complaints. Not a powerful motivator for our
hypothetical AG. “But wait!” he might think, “Even though
the damage may not be material, this company is giving them false
Hope! We have to stop that.” Now hold on a second, what was the
slogan of perhaps the most persuasive political candidate in the
adult lifetime of most people reading this? What was his campaign
slogan? Hope. Let me assure you, if there is one thing the American
political system is not prepared to deny the voters, it's hope.

Well
what about the possibiltiy of HLF running out of "suckers" to peddle their products? Well, the trouble for Ackman is that, as far as suckers
go, there's another one born every minute. Not only that, though we
may have more than our fair share, they make suckers outside the US
as well and HLF is all over them. The company operates in 88
countries and though their main growth is in established markets
they're not going to run out of people who are concerned about their
waistlines or want to be millionaires any time soon. This is borne
out by the earnings of the company which have been remarkably
consistent as you can see.

So
where does that leave Ackman? Well, he has a massive position that is
cost prohibitive to close in the open market, he may have seriously
misunderstood the incentive structure in which the regulatory
authorities operate, and he may have to wait for HLF to run out of
countries to open in before the economics start affecting the stock
price. This isn't a great position to be in, but it's actually worse
than that.

If
I had to bet, I'd say that what drew Loeb into this wasn't the
economics of HLF but the size of the Ackman short. As Kyle Bass mentioned, being on the other side of Dan Loeb is bad enough, but
then Carl Icahn hopped into the mix and now everyone is talking about
a “short squeeze.” For a discussion of this and why I think it's
unlikely I need to talk a little about what precisely a short squeeze
is, so bear with me.

Short selling is where you borrow the shares of
a company from someone and sell them in the open market. Then at a later date you buy
them back, hopefully at a lower price, and return them to the person
from whom you borrowed them, keeping the difference in price. The lender of the shares is paid a small
fee for this called “the borrow cost” which varies with the
supply of shares that can be lent and the demand for borrowing them.
The way the market generally works is that as part of the custody
agreement that an investor will sign with his custodian the investor
gives the custodian the right to lend out his shares an the custodian
might share some of the proceeds with the client.

It
was probably quite easy for Ackman to borrow the shares as the vast
majority of the shares of HLF are held by institutions who are more
than happy to lend out the shares for a little more edge or lower
custody fees. There are, however, a few technical issues that the
short seller faces. First of all, the rate at which he borrows the
shares can only be fixed for a certain amount of time maybe overnight
or maybe Ackman negotiated longer terms with his prime broker but
it's not forever and so it is possible that the cost to him over time
might increase. Ackman might have to pay higher costs if borrow gets tight but he's well enough financed that increased costs alone will not be able to force me out ofthe trade.

The more serious threat is that the HLF shareholdersfrom whom Ackman borrowed might
want their shares back in a hurry. In that case Ackman would have
to go out and buy them at whatever price he could get or make a off exchange arrangement to get them from a large holder. There
are two ways in which Ackman might be forced to close his short at
what would be, given the lack of liquidity, ruinous prices.

The first
is one where all the shareholders needed to have their shares in
their physical possession, such as in the case of a tender offer. In
the event of a take-private transaction,
someone would make a tender offer for the shares, say at $55 a share
and everyone who wanted to get $55 would have to get possession of
the shares and tender them to the buyer. So when Fidelity or some
other company goes to their custodian to get the shares, the
custodian would turn around to Ackman and say, “OK, games over,
give us the shares back, we have to turn them over to their original
owners.” Then Ackman has to go get them at whatever price he can which, as discussed, might be quite high indeed.

Interestingly
the tender offer doesn't even have to be for the whole company, even
a partial tender would destroy Ackman. Imagine the following
scenario: the company says, “OK, we've got $787 million left on our
buyback. Here's what we're going to do. We're going to take $750 million of that and offer to buy 15 million
shares at a price of $50 from anyone who tenders their shares to us
on March 31st. In the event of an oversubscription shares
will be bought on a pro-rata basis from those who tender their
shares.”

That is let's say you have 1,000 shares of HLF. You tender them to the company and let's say that they get
a total of 30 million shares tendered to them, twice what they are offering to buy. What happens is this: they send you a check for $25,000 and your other 500 shares back. With the stock trading at $37, I think quite a few people would tender their
shares at $50 even if they knew the tender would be oversubscribed. As mentioned, they would need actual possession of the shares
to submit them to the tender. Thus their custodians would have
to deliver them to the company which means they would have to get
them back from whomever they lent them. So you see, a partial tender is just as dangerous for Ackman as a full take-private transaction.

That said, I don't think either a partial or full tender are likely to happen. From their recent 10Q, the company only has $350
million in cash. Sure they could borrow the money
from Icahn, but it might be hard to justify in subsequent lawsuits why
you spent the shareholders money buying back shares for $50 though a
tender when the shares are out there in the market offered at $37. I
also don't think that Icahn is likely to tender for the whole
company. Even in the event that it's actually worth $70 a share or
more, that doesn't provide nearly the margin of safety required to
handle the additional debt the company would have to take on in order
to buy back the shares.

The second thing that might force Ackman to close is if enough holders
simply refused to let their custodians lend the shares drying up the pool
from which Ackman is borrowing. This is the theory that people who are rooting for a squeeze post the Icahn options exercise believe. It's true that Icahn will probably withdraw his
shares from the borrow pool once he exercises his options,but I
don't think that will decisively affect Ackman's borrow cost.

First of all, while it's true that institutions are probably
selling HLF and hedge funds who think the stock is cheap and/or
subject to a squeeze are buying them, you would need an awful lot of
people to cooperate in order to lock up enough stock to force Ackman
to close. Even at it's zenith the short interest in HLF was 37 million shares leaving more than 60 million out there. At the time, you could still borrow it, it was expensive, but it could still be done. So even if Ackman and Lobe both locked up their shares and as many people piggy backed Ackman as in late December, there are still more than enough shares for Ackman and let me assure you he is getting better terms than any of the other shorts so he'll be the last guy to get forced out. What's more is that engineering a short squeeze is a non-trivial undertaking and it requires a high level of trust among the participants. Imagine the following. You're a hedge fund manager and you've been following this whole thing. Then one day you get a call from Icahn who says that he's putting together a team to run up the stock price of HLF and try to squeeze Ackman. He asks for you to participate by buying some shares of HLF and locking them up, preventing Ackman from borrowing them. Let's say you do this and sure enough the stock starts floating, then leaping, then screaming higher.

This presents everyone involved in the short squeeze with a dilemma: do I close out, take the money and run, or do I stick around and wait till Ackman folds? The trouble for the squeezers is that if enough of them close out, the squeeze is over before Ackman gets pushed out and the stock crashes back to Earth burning them all. This isn't even the worst case scenario. Imagine a world in which Ackman is able to negotiate with a few of the squeezers in order to safe himself and he does an off exchange transaction to close his position. Everyone who is not in on it is holding the bag when it is announced that the squeeze is over because Ackman is out. Then remember that the leader of the anti-Ackman faction is Carl Icahn, is he the kind of guy you would have to be worried about cutting a separate deal for himself with Ackman? Yes he is. Thus I think it will be very very hard to engineer a squeeze.

The
last thing that might force Ackman to close out is that he just runs
out of money to maintain the position. Recently there was a bizarre Reuters article that claimed that since Ackman put up cash to fund his short position in HLF that he was not vulnerable to a short squeeze. This is preposterous. It's true that he's not borrowing money, but it is also true that he IS borrowing shares and therefore there is a price at which he may have to buy back those shares which would exceed his capacity to do so. His prime broker is well aware of this fact and so in the event that the shares go higher he is going to have to put up more cash in order to maintain the position.

The thing is, for Ackman, it
doesn't even have to be losses on HLF itself that force him out.
Ackman is the head of Pershing Square Capital, a hedge fund
that has concentrated positions in a number of companies.
Even in the event that he fully funded the HLF short with cash as
Reuters alleges, it is important to remember that Ackman's positions are almost certainly is cross margined.Thus the exposure of the entire firm needs to be taken into consideration. If a reversal in the fortunes of JCP, or Canadian Pacific depletes the capital of his firm, his prime broker may force him to trim his risk in HLF and as discussed, once the hype dies down and it's only trading 1.5 million shares a day, that could take some doing. Personally I don't think
this is likely to happen any time soon but it is a possibility and it
is an issue that Icahn does not face. Icahn has the money, and it's
his money.

So
where does that leave us? Basically it leaves us in a waiting game
between Ackman and Icahn, something totally different than the
exciting clash of wills that is being portrayed in the press. Whether
HLF is a pyramid scheme or not is only cosmetically the central issue. For Ackman to
win it is necessary condition that HLF is a pyramid scheme but it is not a sufficient condition.
Either the company must be investigated and destroyed by the
authorities or they have to be destroyed by
the economics of being a pyramid. And one of those things has to
happen before 1.) someone decides to initiate a tender or partial
tender offer. 2.) either losses in HLF or elsehwere or redemptions from his fund force
Ackman to close the position. Since none of these events is likely to
happen in the near term, by far the most likely outcome is that the
company continues to operate as it has for the preceding 30 years,
and the stock grinds higher albeit with a lot of volatility as all
the weak hands piggybacking Ackman and Icahn are shaken out with each
new announcement of positive or negative news.

So
what's Icahns game in all this? I'll tell you. Icahn
doesn't need to actually cause Ackman to be forced out, he just needs
to be there when it happens. You see, if and when Ackman goes to the
wall, for whatever reason, it will not be possible for him to close
out his position in the open market. It's simply too big and the
market is too thin. He's going to have to negotiate a private
transaction with someone who can give him the shares he needs and
he'll have to pay whatever price that guy wants. Icahn wants to be
that guy. Doing off market transactions in size with a highly
motivated counter-party is what made Icahn famous back in the 1980s.
I'll tell you what though, you don't want long HLF when that happens
because once the drama is over, the stock will crater the next day.
The retail daytraders may help Icahn run up the stock, but for the same reasons other hedge fund managers will hesitate to get involved in a squeeze, they won't
be part of the payoff. In the meantime Icahn gets to buy a large
stake in a company that is growing at double digit rates for about a
9 PE and when Ackman needs him, he knows how to find him.